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IRS rules on estate tax treatment of joint trust created in non-community property state

Several non-community property states have recently enacted statutes authorizing the creation of a joint trust by spouses that would be treated as entireties property, protected from the creditors of either spouse during their joint lifetimes, but would split into a separate Family Trust and Survivor’s Trust when one of them died. The question many estate planning lawyers have raised is whether the Family Trust would be includible in the survivor’s estate for Federal estate tax purposes when the survivor died. This question has now been answered at least as to one taxpayer in a private letter ruling, PLR 201429009(released 7/18/2014).

In this private letter ruling, a Husband and Wife created a joint revocable trust. During their lives, they contributed their joint property to the trust and the trust provided that each of them held an undivided one-half beneficial interest in the trust as tenants in common and not as joint tenants.

On the death of Wife, the trustee was to divide the joint trust into a Family Trust with Wife’s trust assets and a Survivor’s Trust with Husband’s trust assets. Husband could amend and revoke the Survivor’s Trust, and on the death of Husband, he had a general power of appointment over the Survivor’s Trust.

The Family Trust, however, was to be held for the benefit of Husband for his life, with the net income and principal distributed to Husband for his health, education, maintenance and support in the discretion of the trustee. Husband also had the noncumulative power to withdraw the greater of $5,000 or 5% of the value of the Family Trust each year.

This plan is commonly accomplished by each of the spouses setting up a separate trust that would create the Family Trust on the death of the first of them to die, funded with their own assets. Here, however, this plan was imbedded in a joint revocable trust to which both Husband and Wife contributed.

In addition, after the death of Wife, Husband continued to serve as the sole Trustee and, upon receiving faulty advice from his attorney and accountant, for years did not segregate the assets into the two separate trusts, the Family Trust and the Survivor’s Trust. Instead, Husband continued to administer the trust as a combined trust, until right before his death when the trust was divided into the Family Trust and the Survivor’s Trust through a forensic review of the combined trust assets, allocating all distributions of principal to the Survivor’s Trust. The income tax returns for the Family Trust were then amended and income tax returns for the Survivor’s Trust were then filed.

After Husband’s death, the executors of Husband’s estate requested this ruling that the Family Trust was not includible in Husband’s gross estate for Federal estate tax purposes. Although the trusts had been administered as a combined trust until right before his death, Husband used a forensic determination as to the property that was contributed by Wife, and that property was allocated to the Family Trust.

The Service concluded that the value of the property that could be identified as specifically attributable to Wife and allocable to the Family Trust would not be includible in Husband’s gross estate, except to the extent of Husband’s 5 and 5 power.

Although private letter rulings are not binding on any taxpayer other than the one that requested the ruling, this ruling seems to bless the estate planning use of a joint trust in a non-community property state, enabling the survivor to exclude the property allocated to the Family Trust from his gross estate, even if the survivor continued to manage the assets in a combined trust, so long as the property can either be specifically identified or proportionately identified as properly allocable to the Family Trust.

There are still outstanding questions, however. In this case, the couple specifically identified the property jointly contributed to the trust as tenants in common property, with each of them owning an undivided one half interest. Was this fact essential to the ruling? Does a couple have to treat the property in the joint trust during their lifetimes as the separate interest of each to receive this favorable ruling?